Pricing Decisions
Notwithstanding the view just expressed, top management sometimes has failed to take anticipated exchange rate changes into account when making operating decisions, leaving financial management with the essentially impossible task, through purely financial operations, of recovering a loss already incurred at the time of the initial transaction. To illustrate this type of error, suppose that GE has priced Lufthansa’s order of turbine blades at $15 million and then, because Lufthansa demands to be quoted a price in euro, converts the dollar price to a euro quote of €10 million, using the spot rate of $1.50/€.
In reality, the quote is worth only $14.79 million—even though it is booked at $15 million—because that is the risk-free price that GE can guarantee for itself by using the forward market. If GE management wanted to sell the blades for $15 million, it should have set a euro price equal to €15,000,000/1.479 = €10.14 million. Thus, GE lost $210,000 the moment it signed the contract (assuming that Lufthansa would have agreed to the higher price rather than turn to another supplier). This loss is not an exchange loss; it is a loss due to management inattentiveness.
The general rule on credit sales overseas is to convert between the foreign currency price and the dollar price by using the forward rate, not the spot rate. If the dollar price is high enough, the exporter should follow through with the sale. Similarly, if the dollar price on a foreign-currency-denominated import is low enough, the importer should follow through on the purchase. All this rule does is recognize that a euro (or any other foreign currency) tomorrow is not the same as a euro today. This rule is the international analogue to the insight that a dollar tomorrow is not the same as a dollar today. In the case of a sequence of payments to be received at several points in time, the foreign currency price should be a weighted average of the forward rates for delivery on those dates.